Tax Court denies C corporation sec. 104(a)(2) personal injury exclusion.

In P&X Markets, 106 TC No. 26 (1996), the Tax Court recently ruled that a C corporation cannot suffer a personal injury and, therefore, cannot exclude personal injury damages under Sec. 104(a)(2)

Sec. 61(a) taxes all income unless specifically excluded by another Code section. Sec. 104(a)(2) excludes from gross income "the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness." Regs. Sec. 1.104-1 (c) specifies that the taxpayer's claim must be based on tort or tort-type rights. (A tort is a civil wrong, other than breach of contract, for which a court awards damages.) The exclusion applies to physical, mental and emotional injuries; "person al injury" is not defined in the statute or: in the regulations. In Schleier, 115 Sup Ct. 2159 (1995), the Supreme Court denied the Sec. 104(a)(2) exclusion to employees subject to age discrimination by narrowly interpreting"on account of personal injuries" and"tort-type rights." However, the Supreme Court did not define"personal injury."

In P&X Markets, a C corporation owned and operated a retail grocery store. The corporation's president was its sole shareholder. P&X Markets sued certain defendants for breach of contract, malicious prosecution, injury to P&X's reputation, intentional interference with P&X's business and fraud. The parties settled for $850,000. The settlement did not allocate the $850,000 among the various claims, some of which qualified as tort-type under Sec. 104(a)(2).

P&X reported only $83,608 on its 1989 Form 1120, U.S. Corporation Income Tax Return. (Presumably, this was P&X's estimate of the portion of the $850,000 that was not for tort-type claims.) The IRS included the difference, minus legal fees, in income. P&X argued that the settlement proceeds were for personal injury because the defendant's wrongful conduct fell entirely on its sole shareholder/president. P&X also cited Castner Garage, 43 BTA 1 (1940), in which a corporation was allowed a personal injury exclusion.

The Tax Court rejected these arguments and held that a corporation cannot suffer a Sec. 104(a)(2) personal injury. The Tax Court cited Boyette Coffee Co., 775 F Supp 1001 (CID. Tex. 1991), in which a district court held that Sec. 104(a)(2) applies only to individuals, not to corporations. The court in Boyette pointed to other provisions of Sec. 104(a),which exclude from gross income payments for workers' compensation, health insurance benefits, and certain payments due to injuries from military service or terrorist attack. The court emphasized that these other exclusions apply only to individuals. Neither Boyette nor P&X Markets defined "individual," but the context indicates that the courts meant "human being."

In addition to Boyette, the Tax Court based its opinion on two footnotes from previous Sec. 104(a)(2) cases; in these cases, the taxpayers were individuals (an employee in one case and a sole proprietor in the other). In Roemer, 716 F2d 693 (1983), the Court of Appeals stated that"a corporation by its very nature cannot suffer a personal injury. A corporation is a business entity and not a human being." The Tax Court's footnote in Threlkeld, 87TC 1294 (1986), was similar: "Although a corporation is treated as a 'person' for many purposes, it is, nonetheless, a business entity and not a human being."

In P&X Markets, the Tax Court noted that P&X must accept the burdens as well as the benefits of the corporate form. In Castrler Garage, the excluded payment was received by a corporation due to the sickness of the corporation's president; this injury was to a human being, but the proceeds were received by someone other than the injured party. However, in P&X Markets, the corporation actually suffered the injury.

Clearly, a C corporation is not eligible for a Sec. 104(a)(2) exclusion. Therefore, practitioners should advise corporate clients that they should consider this in determining the amount of damages asked for. However, this decision did not address the eligibility of other business entities, such as S corporations, limited liability companies (LLCs), limited partnerships, limited liability partnerships (LLPs) and general partnerships. Consequently, it is uncertain how the Tax Court would rule on the applicability of P&X Markets to these entities. Since S corporations and LLCs are legally separate entities with limited liability, the Service can be expected to argue that P&X Markets applies to them. On the other hand, general partnerships are not legally separate from their owners and do not offer limited liability. Therefore, taxpayers would have a stronger argument that general partnerships are eligible for the Sec. 104(a)(2) exclusion. Despite their name, LLPs differ from general partnerships only in that a partner in an LLP is not liable for the torts of other partners. Hence, they are arguably similar to general partnerships for Sec. 104(a)(2) purposes. Most problematic is the limited partnership form, in which all partners have limited liability except for the general partner.

From Peter C. Barton, CPA, MBA, J.D., Professor of Accounting, and Clayton Sager, PH.D., Associate Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, Wisc.